An Argument For Index Funds

By consumerist.comJanuary 15, 2007

FreeMoneyFinance has a nice piece on why he invests mainly in index funds.

Index funds are a type of collective investment that attempts to mirror the performance of a particular financial market. For instance, the S&P 500 or the Vanguard MidCap Index. Index funds are often automated and can achieve significant investor savings by virtue of their lack of over human involvement.

FMF finds index funds:

• deliver higher returns
• (partially attributable to their low cost)
• require less time to manage
• and are easy to manage

This is why The Motley Fool calls index funds, “a wonderful option for the know-nothing investor.”

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Its actually really REALLY hard for an actively managed mutual fund to beat an index fund (there is some pretty heavy math behind why index funds work so well). When you add in the much lover overhead (active funds can be 2%+ in cost, while index funds are

Index funds are not just for “Lazy, know nothing” investors, but also pretty sophisticated investors who want some particularly nice points on the risk/return curve.

If you don’t understand how the market works you should not be investing. There are already too many people with no idea what they’re doing investing via their 401k. That’s how markets built on speculation and “irrational exhuberance”, to quote Greenspan, get built.

The most cost efficient way to buy into an index is not through a mutual fund — but through what are called Exchange Traded Funds (“ETFs”). The expense ratio for the S&P 500 ETF (known as CUSIP SPY) is 0.9% — whereas the expense ratio for the largest S&P 500 index fund through Vanguard Funds is 0.18%. The disparity is even greater with smaller indexes. For more research, I suggest http://www.ishares.com. (I am not a broker, nor do I sell financial advice.)

Picking one or the other depends on, I think, how often you put money into the index. If it’s relatively often, say, through some sort of automatic withdrawal, the mutual fund might be better, because buying the ETF will require brokerage commissions. Large lumps of money might work better with ETFs, as the commission becomes less significant, and the lower expense ratio makes up for that cost (though FXMKX’s low expense ratio is hard to beat; Fidelity also offers an S&P 500 index with an expense ratio of around 0.07%, but you have to drop $100K in to start with, which is, you know, kind of high).

There’s no cut and dried rule: it depends on what you’re doing, how frequently you’re contributing, etc.